Coal's Brightening Outlook

2010 has been an interesting year, to say the least, for the United States coal industry. We think coal miners' fundamentals have generally improved dramatically since last year, shaped by several powerful trends in the U.S. and Asia. However, we are also likely to see an accelerated deterioration in the iconic Central Appalachian basin for the next several years, shifting economic rents toward players in more prolific and lower-cost regions.

Last year was a terrible one for the coal industry. Demand fell around an unprecedented 10% for the year. The coal industry was ill-prepared for such a drop, and inventories ballooned in response. This inventory overhang, along with weak natural gas prices and economy, were the primary overhangs on coal companies in late 2009. However, recent events have alleviated these worries greatly.

Tragedy Is Secretly Good for Coal Producers

Thanks to hot weather, higher natural gas prices, more industrial activity, and greater exports, coal demand improved materially in 2010. But contrary to expectations, coal supply is flat to down slightly, which is remarkable considering how far the industry pulled back in 2009. As might be expected, rising demand and falling supply has been a welcome stimulus for coal pricing and therefore profitability. Moreover, inventories are falling faster than people would have dared to hope for a year ago. With the inventory bubble deflating rapidly, coal companies are in an excellent bargaining position as we enter the 2011 contracting season.

One of the biggest drivers of this surprising trend is the tragic Upper Big Branch mine disaster in April 2010, which was the deadliest in decades. Twenty-nine miners lost their lives in the West Virginian Massey Energy (NYSE:MEE) mine due to a methane explosion.

The accident instantly focused regulatory spotlights on the underground coal mining industry. Although no verdicts have been pronounced regarding the root causes of the accident, safety regulators have stepped up enforcement and inspections and miners have become more cautious as well. As a result, productivity, particularly for underground Central Appalachian mines, dropped. Production volumes fell, and costs rose. Year to date, U.S. coal production is down about 1.5%, with little sign of recovery.

So far Massey Energy--the owner of the mine--has been the most affected. But eventually, stricter safety legislation and stiffer penalties will raise costs permanently, discouraging production across much of the industry. Of course, Central Appalachian miners like James River (JRCC), International Coal (NYSE:ICO), and Alpha Natural Resources (NYSE:ANR) will be most at risk. But all underground coal mining will be impacted to some extent.

There will be some winners and losers from this trend. For instance, Massey Energy is a clear loser. Other Central Appalachian miners will probably be long-term losers as well. For example, 2010 Central Appalachian production has been the weakest among all major U.S. basins, a trend that will probably continue for the foreseeable future.

In our opinion, companies dependent on efficient large-scale surface mining, especially the ones in the Powder River Basin, are the clear winners. Peabody Energy (NYSE:BTU), Arch Coal (NYSE:ACI), and Cloud Peak (NYSE:CLD) are in this camp. The line is a bit more blurry in other coal basins. But we think the Illinois Basin and Northern Appalachia are net beneficiaries as well, thanks to their larger-scale mines, less challenging geology, and favorable access to markets. CONSOL Energy (NYSE:CNX) and Alliance Holdings (NASDAQ:AHGP) (NASDAQ:ARLP) are in this category.

China and India--the Familiar Story

The other mega-trend that will profoundly impact U.S. coal companies is soaring demand from Asia. The Pacific markets are increasingly short of coal, mostly thanks to China's voracious appetite. India is not far behind; if its economic growth continues, its import needs may soar in the years ahead. As a result, Asian coal prices are much higher than prices elsewhere, sucking in supplies from all over the world.

For the past year or more, this has been a prime driving force behind the coal industry. It's structurally very difficult for traditional exporters such as Australia or Indonesia to satisfy Chinese and Indian demand if demand keeps rising at the current pace. If this rosy cycle continues, coal companies all over the world will benefit from rising prices and margins. The U.S., being a marginal swing supplier in the world, will arguably benefit more than most.

However, in recent weeks we've seen some troubling signs. China's economic and industrial production growth is slowing, and key industries like steelmaking (which requires very expensive and profitable metallurgical coal) are slowing even more. There are widespread concerns about the imbalances within the Chinese economy and the future of its macroeconomic policies. We do not know the answer to these questions. We think the lower-cost U.S. miners are favorably positioned no matter what happens with Chinese demand. Their cost positions should allow them to realize at least acceptable margins in almost every economic scenario. However, if the world economy returns to business as usual, margins are sure to expand as well. Our favorite pick in this space is Cloud Peak Energy, a pure-play Powder River Basin miner blessed with an unparalleled cost position and bountiful reserves.

Outlook for 2011

Coal companies largely survived 2009 in fine shape. Favorable contracts made in good times allowed margins to stay high, and dramatically lower capital budgets across the board allowed robust free cash flows. 2010 is shaping up favorably as well. Metallurgical coal prices have soared this year as steel production bounced back, and companies are scrambling to adjust their production mixes to maximize their sales into this market. However, if China slows further later in the year, this source of easy profits may weaken markedly.

From the information we have today, 2011 will be a very good year for coal companies. Many firms have already committed significant percentages of their thermal coal outputs for the year at favorable prices. However, many metallurgical tons remain unsold. That said, despite a slowdown in met markets, spot pricing remains robust, which promises fat margins next year. Broadly, we expect flattish production but higher margins, which should allow for improving cash generation in the year ahead.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes. Tim handles their stock strategist posts (separate feed) if you need help formatting or have other Morningstar-related questions.

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